Question

1. How do bid-ask spreads affect arbitrage?
2. How does arbitrage affect financial markets?

Answer 1

Part A ) Bid-ask spread is the difference between the bid price and the ask price.

Let's understand this by an example.

Bid price 100.5 and ask price is 101. Here the spread is 0.5 and this creates an arbitrage opportunity.

Suppose you place a market order to buy then you would buy the stock at 101 and simultaneously place a market order sell then you would sell the stock at 100.5. So this will create a loss of 0.50 per share.

We can take the advantage of bid ask spread by buying or selling in different exchange or different type of market. For example buying in future market and selling in equity market

Part B ) Arbitrage helps in different markets to converge ultimately . Eg. If a stock is priced at 100 in future market then taking the impact of interest rate the equity market should have the same price as discounting the interest rate from the future price.